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2025-01-24
Yields on U.K. sovereign bonds have surged to levels not seen since the Great Financial Crisis and the Sterling too is struggling
In recent weeks the U.K. bond market has been thrust into the spotlight as the yield for British sovereign bonds (gilts) soared. This substantial rise was part of a global bond sell-off but U.K. gilts have been hit particularly hard because the new government is facing a difficult mix of economic hurdles and policy challenges. This week’s chart of the week shows the negative relationship between 10-year gilts and Citi’s positioning alert indicator (PAIN). The indicator reflects the positioning of traders in a certain currency against the U.S. Dollar. A negative reading implies that investors are short selling Sterling and buying the U.S. Dollar.
For investors the question is why the U.K. gilt market has become the epicenter of recent global bond market turmoil. The explanation lies in a combination of factors. Although the latest inflation figure was slightly below expectations, at an annual rate of 2.5% in December 2024, persistent service price pressures could still limit the Bank of England's flexibility when it comes to lowering rates. At the same time fiscal concerns have intensified. The government has little room for maneuver because the level of public debt has risen fast in recent years and surpassed 98% of GDP in Q4 2024. In addition, the current elevated yields will increase the government’s refinancing costs.
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Source(s): Macrobond Financial AB, DWS Investment GmbH as of 1/15/25
Weaker than expected economic growth, especially compared to other developed markets, have further worsened the government’s position. Chancellor Rachel Reeves committed the government to tight fiscal rules and also promised not to raise taxes. Unless the government amends its policy, this implies spending cuts could be necessary – which would be likely to do further harm to the U.K.’s growth prospects.
As if this news were not enough, Citi's PAIN index has plunged from -35 to below -75 since November last year, reflecting investors’ preference for the U.S. Dollar compared to Sterling. U.S. Treasury bonds offer similar yields but the U.S. economic outlook is much brighter. What looks particularly worrying is that rising yields usually provoke an appreciation in the currency, but the pound too has been falling. This may reflect general skepticism on U.K. risk-assets.
Although the current outlook is gloomy, a further rise in yields could entice marginal buyers to lock in solid long-term returns. This, combined with benign inflation and a return in investor confidence, could potentially ward off serious fiscal and financial repercussions. But the U.K. does need to restore confidence in its growth prospects and fiscal plans.
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